Mon Jan 9th, 2006 at 05:40:34 PM EST
To economists, growth in labor productivity - output per labor input - is ultimately the only way to create sustainable increases in living standards.
Thus the fact that Europe appears to have fallen behind the United States in labor productivity growth in the last half-decade or so may be cause for alarm. Or is it?
The chart shows that the European Union as a whole has seen a fall-off in productivity growth since 1995, while in the US productivity growth has accelerated. What explains this pattern?
Investment in Information Technology
According to Brad DeLong, part of the story is investment in information technology:
Nearly all agree that the cause of the [US] productivity growth speed-up of the 1990s lie in the information technology sector. It is the result of the extraordinary wave of technological innovation in computer and communications equipment - solid-state electronics and photonics.
Increased total factor productivity in the information technology capital goods-producing sector coupled with extraordinary real capital deepening [that is, the benefits of rapid information and computer technology investment to the users of ICT capital] as the quantity of real investment in information technology capital bought by a dollar of nominal savings grows have together driven the productivity growth acceleration of the later 1990s.
Interestingly, though, the pattern of productivity growth in the United States has not been uniform across industries:
We now know that all of the difference between Western European and American productivity growth rates in the late 1990s is due to wholesale and retail trade, financial transactions, and other service industries that intensively use information and communications technology [ICT]. Measured American labor productivity growth in these sectors acclerated from 1.6 to 4.8 percent per year between the early and the late 1990s . . . It's not that the rest of the computer-intensive American economy is doing badly: the productivity acceleration in ICT-producing manufacturing has grown even faster, and the acceleration in ICT-using manufacturing is clearly visible as well.
So the accleration of productivity growth in the US has been concentrated in manufacturing sectors that produce information technology or service sectors that use it intensively. So why do we see these big differences in productivity growth across U. S. industries?
Information Technology and Business Reorganization
According to Northwestern University economist Robert Gordon:
[Information technology investments] require complementary inventions and business reorganization to become fully effective. The role of business reorganization and process improvement in the form of "intangible capital" that is complementary to ICT investment has been the focus of recent interpretations of the post-1995 productivity growth revival . . . argu[ing] that measured investments in computer hardware and software require complementary, unmeasured investments in intangible capital, including business reorganization, new business processes, retraining, and general acquisition of human capital.
So just simply buying the new IT equipment is not enough; firms also need to update the way they do business. What kind of reforms are needed? Investments in worker skills and giving workers more voice on the job:
Often IT spending is only the tip of the iceberg - there are a whole host of other investments made in the firm to enhance the use of IT - consultancy expenses for example. Skills are also important: there is a lot of evidence that educated workers tend to be much better at coping with the uncertainties of new IT systems than less skilled workers. Other organizational factors such as decentralisation of decision making and the steepness of the managerial hierarchy have been found to be important. Old-style "Tayloristic" organizations are characterized by large bureaucracies, rigid and centralised hierarchies where decisions made by senior managers are cascaded down to people below. These firms have, on average, produced much lower returns to IT than more "organic" flexible firms with flatter hierarchies, less centralized control and more autonomy for lower level employees.
It seems that some US service-sector firms have taken the lead in making these changes:
We know the American companies that are leading this productivity revolution driven by the application of information technology to distribution: WalMart, Amazon, Land's End . . .
The European Productivity Slowdown
So what does all of this have to do with slow European productivity growth? It seems that Europe has lagged behind the United States in terms of utilizing information technology.
Social savings is an estimate of the impact of a given technology on the economy. The basic idea is: how much are costs reduced by using a technology relative to its' next best alternative? It is clear that the "Anglo" nations - the United States, UK, Australia, New Zealand - have outdistanced Continental Europe in terms of utilizing information technology.
Now go back and take a look at the second chart above. It is clear that whatever productivity advantage the US has does not originate in IT-producing sectors. European productivity growth has accelerated there just as fast as in the US. No, the real secret of US success lies in the IT-using sectors. Apparently American firms have been quicker than their European counterparts at both investing in information technology and in undertaking the business process reorganization needed to realize ITs full potential:
[P]lants belonging to US multinationals appear to be more productive than non-US multinationals. This is true both within the United States and in other countries. . . . In terms of value added per worker US multinationals are 23 per cent more productive than the industry average. Non-US multinationals are 16 per cent more productive than the industry average and domestic plants are about 11 per cent less productive. In terms of output per worker the US advantage over domestic firms is 21.5 per cent and non-US advantage is 17.5 per cent. This is consistent with evidence that the plants of multinational US firms are more productive despite whether the plants are based on US soil or foreign soil.
The US productivity advantage is partially linked to greater use of inputs: US establishments use about 10 per cent more materials and 4 per cent more non-IT capital than non-US multinationals. But . . . IT capital may also be a very important factor: US firms use a whopping 40 per cent more IT capital per worker on average whereas non-US multinationals use only 20 per cent more.
But this difference in the usage of IT is only one part of the story. . . . What mattered was the way that US firms used IT. A doubling of the IT stock was associated with an increase in productivity of 5 per cent for a US firm but only 4 per cent for a non-US firm. US firms appeared to simply get more productivity out of the same amount of IT (this was not true of non-IT capital).
. . . the bigger returns to IT usage for US firms were only found in certain sectors of the economy. These were exactly the same "IT-using" sectors of wholesale and retail that accounted for the US productivity miracle discussed above. In other words it was only in the IT using sectors . . . where US firms' IT productivity was much higher.
. . . Why were the returns so much higher for US firms? We investigated a wide variety of hypotheses, including whether the US firms simply had more skilled workers or better software? Neither of these seem to be the culprit, rather, we suspect that the main reason lies in the managerial structure of US firms. . . . on a range of managerial "best practices" such as incentives (e.g. merit-based promotion and pay), the use of lean manufacturing techniques, performance management and effective targets. . . . US firms were significantly better managed on average than European firms. Looking within Europe at US subsidiaries we also found that they were significantly better managed than non-US subsidiaries and domestic firms. Furthermore, US subsidiaries were also much more likely to allow greater autonomy to employees (a factor associated with higher returns from ICT). This suggests that what gives US firms their advantage is their organisational and managerial structures that enable them to get the most out of their technology.
So why has Europe apparently failed to make the needed investments and reorganization?
Rigid Labor and Product Markets
Yes, here we go again. Many believe that European productivity growth is being clogged up in bureaucracy and excessive regulation. Actually, there seems to be some truth to this. There is a much stronger correlation between employment deregulation and the social savings associated with IT than with, say, unemployment rates:
Every 5-point reduction in the employment protection index is associated with about
1% 0.1% of GDP more in social savings associated with IT.
So it may well be that this is one area where labor regulations really are hurting the European economy:
[B]usinesses invest heavily in high-tech only when they can smell immediate productivity gains from reorganization and restructuring, and European red tape keeps firms from being allowed to reorganize and restructure.
[T]here are regulatory and cultural constraints to adopting US business practices in Europe. For example, removing poorly performing workers is extremely difficult especially for longer tenured workers in larger firms. This is due to strong labour regulation protecting workers against dismissal. These enable managers and workers to block changes that may threaten their vested interests. Rapid promotion of very talented workers is also problematic as young employees are often expected to go through extensive training and unions prefer tenure based promotion systems to those based on individual performance.
In the US, change often occurs due to the entry of new firms and plants but this is difficult to bring about while there are entry regulations protecting incumbents against the threat of new entry. All of these barriers should not be over-emphasised however, as US multinationals appear to be able to do as well in the European outlets as they do back home (Starbucks, McDonalds, etc).
Product market regulation may also have held Europe back in this regard:
As recently as the mid-1990s ICT equipment was much more expensive in EU countries than in the United States. Even in the UK where the differential was least prices were about 30 per cent higher than in the United States, in Germany the gap was 45 per cent whilst in Portugal it was as high as 75 per cent. These price differentials, which presumably reflected barriers to trade, taxes, and weak competition, suggest that European slowness to follow the American lead in regulatory reform may have been unfortunate. The demand for computers has been shown to be quite price-sensitive and the implication of high ICT equipment prices was a delay in accumulating the knowledge and intangible organizational capital necessary for exploiting the potential of (and enhancing the returns to) ICT. EU investment expenditures on ICT rose from 2.2 per cent of GDP in 1990 to 2.9 per cent of GDP in 2000, about what the United States was already spending in 1980.
Or so the theory goes. Still, there are exceptions - labor market regulations have not stopped Sweden or New Zealand from achieving impressive levels of IT investment and cost reduction (or US multinationals located in Europe, for that matter). Low levels of regulation have not helped Ireland or Canada achieve US-levels of IT productivity.
Back in 1987, Robert Solow famously remarked that "we see computers everywhere but in the productivity statistics." This was in the middle of the great US productivity growth slowdown of 1973 to 1995, when European labor productivity growth rates were roughly double those of the US, and in the middle of a great investment boom in information technology.
This provides a popular explanation for the US productivity slowdown. Professor Gordon:
Numerous observers . . . argue . . . that there is in fact a substantial delay in reorganizing business practices to take advantage of new hardware and software. . . . . . . [T]he role of delayed benefits from the rapid growth in ICT investment in the late 1990s seems incontrovertible. Jeffrey R. Immelt, chief executive officer of General Electric, refers to the delayed benefits of ICT spending by saying, "It takes one, two, three years to get down the learning curve and figure out new ways to use it." Cisco CEO John Chambers estimates the learning curve at more like five to seven years. . . .
[G]rowing sectors--even rapidly growing sectors--don't have an impact on the economy as a whole until they achieve critical mass and can be applied to a large chunk of the entire economy. This lesson is very old. It was first taught by those who noticed that historians of technology date Britain's industrial revolution to 1780-1830 (the age of the key inventions) while social historians date it to 1830-1870 (when steam, iron and the factory achieved critical mass and turned Britain from a nation of shopkeepers into one of factory workers).
By this logic, part of the explanation for Europe's current low productivity growth may be that it is now in a similar position to where the US was in 1987. Europe is now making the investments which will bear fruit some 5 to 7 years down the road (remember European investment in IT as a percentage of GDP increased by some 30% during the 1990s).
So why have European firms not adopted American forms of business organisation more wholeheartedly? There is some evidence that they are beginning to do so. For example, the Wal-mart model is explicitly copied by the UK's largest supermarket, Tesco. It has also been transplanted directly, as Wal-mart has acquired Asda which is now the UK`s second largest supermarket. Organisational changes are large and costly events, however, so change is often slow and difficult.